Low volatility and easy credit are boosting asset prices. But according to the late theorist Hyman Minsky, today's stability may be sowing the seeds of its own demise.

Credit has grown rapidly in recent years. This expansion has come in many forms, from home mortgages to newfangled structured products created by clever financial engineers. There are, broadly speaking, two views about these developments. The conventional wisdom -- held by most economists and denizens of Wall Street -- is optimistic. Higher rates of credit growth and increasing levels of leverage, they maintain, are reasonable in light of increasing economic stability.

An opposing view -- held by a miscellaneous bunch, including some notable investors and Wall Street observers -- holds that the massive buildup of debt augurs ill. Drawing on the work of a little-known, deceased economist named Hyman Minsky, the pessimists contend that the recent calm has induced people to take on too much risk. "Stability is unstable," this group says, quoting Minsky. Like the differences of opinion toward the end of the last decade concerning the existence or not of a stock market bubble, the current argument will be settled only by the unfolding of events. Either the prosperity will continue in the years to come, or a financial crisis will occur.

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A BRIEF MINSKIAN ACCOUNT OF THE PAST DECADE

Minsky died in 1996. However, it's possible to construe how he might have interpreted developments in the financial world over the past decade. As we have seen, the New Paradigm made its first appearance in the mid-1990s. Volatility in the stock market dipped to very low levels at around that time. This emboldened market participants. In the fall of 1998, a sudden crisis occurred after the near failure of Long-Term Capital Management, a hedge fund that had taken on extraordinary amounts of leverage.

The Federal Reserve responded to LTCM's problems by organizing a bailout and cutting interest rates. As Minsky might have predicted, this "Greenspan put" encouraged yet more risk-taking. Shortly afterward a bubble appeared in the stock market. During the dot-com frenzy many telecommunications and Internet businesses represented classic examples of Ponzi finance. Their income was insufficient to meet their expenditures, whether for new investment or to meet their debt payments. But as long as the valuations continued to rise, these Ponzi companies were able to attract new finance. When the market turned their fate was sealed.

U.S. companies in general greatly increased their debt levels in the late 1990s. The failure of Enron and WorldCom precipitated a corporate credit crisis. As risk premiums on loans soared, companies moved rapidly to pay down their debts. Many commentators, including present Fed chairman Bernanke, expressed a fear that deflation would ensue. The authorities responded in an appropriate manner. Government spending soared, and short-term interest rates were slashed. The Great Moderation was born.

MR. PONZI BUYS A HOUSE

If one is looking for contemporary evidence to fit Minsky's financial instability hypothesis, there is no better place to start than with the U.S. residential real estate market. Since the economy came out of recession in 2002, the outstanding mortgage debt of U.S. households has increased by more than 60 percent, to $9.5 trillion. This increase is larger than GDP growth over the same period.

As the housing market has boomed, lending standards have deteriorated. The margin of safety has declined both for borrowers and lenders. Banks have raised the maximum they are prepared to lend relative to the value of the property. "Piggyback" loans have allowed borrowers to take out simultaneous second-lien mortgages, further reducing the amount of equity they are required to put into the home. Piggybacks also have enabled borrowers to evade the rules requiring mortgage insurance on highly leveraged home purchases.

Mortgage providers reduced minimum credit scores required of borrowers. The market for so-called subprime lending has experienced explosive growth: More than $2 trillion worth of subprime mortgage loans have been made since 2002. The dangers posed by these loans have been concealed by strong house price inflation. As long as home prices kept rising, credit was available for fresh loans, and delinquencies could be kept in check. Between 2001 and 2003, defaults of subprime loans fell by half.

A number of other corners were cut to make homes more affordable to those without deep pockets. Although the Fed kept interest rates low, borrowers were tempted to take out adjustable-rate mortgages, which had lower monthly payments than traditional 30-year fixed-rate loans. And when the Fed nudged up short-term rates, lenders pushed so-called affordability mortgages with deferred interest payments. Interest-only loans and mortgages with negative amortization became particularly popular in the hottest housing markets, like California, where affordability was the most stretched.

On top of all this, banks are prying less into the private lives of their mortgage applicants. Traditionally, lenders wished to know something of the borrowers' background -- their jobs, their wealth and so forth. In an age of perennially rising home prices, these tedious details could be dispensed with. "Low doc" and "no doc" loans have proliferated. One mortgage provider, HCL Finance, advertises itself as the "home of the 'no doc' loan." Among the products listed on its Web site is the NINJA loan: Even borrowers with "No Income, No Job and No Assets" are welcome to apply.

Then there is the "stated income" loan, known in the trade as the "liar loan." These loans typically require only the applicants' verbal verification of their job history and stated income, not a W-2 form or tax documents. It comes as no surprise that certain borrowers choose to put a gloss on their circumstances when applying for these loans. A survey commissioned by the Mortgage Bankers Association of 100 stated income loans found that more than half of the borrowers had exaggerated their incomes by 50 percent or more.

In August, Larry Goldstone, president of Thornburg Mortgage in Santa Fe, New Mexico, told the Wall Street Journal that "greater competition and the desire to simplify and quicken the loan origination process has led more lenders to extend stated income loans to borrowers with lower credit scores, and higher loan-to-value and debt-to-income ratios than traditionally allowed." Underwriting standards have continued to decline even as the housing market has slowed.

The booming real estate market has tempted consumers to cash out their burgeoning home equity. Mortgage equity withdrawal reached an estimated $500 billion in 2005. In recent years U.S. household savings disappeared as consumer borrowing soared. Paul Kasriel, head of economic research at Northern Trust Co., estimates that household borrowing surged from about 5 percent of disposable income in the early 1990s to nearly 15 percent in 2005, before falling back below 10 percent in 2006. In aggregate, the household sector has been running a financial deficit -- the excess of expenditure over income -- equivalent to about 6 percent of GDP.

The behavior of U.S. households during the real estate boom closely resembles the Ponzi finance described by Minsky. The danger is that when home prices stop climbing, households may have to rein in their spending or sell assets to make good on their debts. When U.S. corporations followed the same course of action after the technology bubble burst in 2000, they induced a recession, followed by a credit crisis and a deflation scare.

OUTSIDE THE HOME

Away from the housing market, much that has occurred in the financial world appears to conform with the type of behavior described by Minsky. A deflationary bust was avoided by the authorities in 2002. But the very success of central bankers' easy-money policies has encouraged people to play with fire. Debt has escalated. Competition among financial institutions has contributed to looser lending standards. New entrants into the credit markets and financial innovations have eroded the power of old regulations to protect the credit system. In many financial transactions the margin of safety has been whittled away.

There's ample evidence that people have responded to more-stable markets by placing larger and more-hazardous bets. The greatest beneficiaries from the decline in volatility have been riskier types of securities. In the stock market that's meant a "dash to trash" as small caps, cyclicals and emerging-markets stocks have outperformed blue chips, which tend to have large market capitalizations and are less exposed to the vicissitudes of the business cycle. Likewise, emerging-markets and high-yield bonds have proved a better investment than government or corporate bonds.

Jan Loeys, the global markets strategist for J.P. Morgan Securities in London, finds "strong evidence that bond managers, credit managers, banks and hedge funds raise leverage when volatility is low." This is hardly surprising. Modern techniques of risk measurement, such as the widely used value-at-risk (VaR) approach, use historical volatility as a proxy for risk. As volatility declines, financial institutions are obliged to increase their leverage to maintain the same risk level. The VaR technique is a kind of financial version of Adams's risk thermostat.

As inflation fears have subsided and the Federal Reserve's moves have become more predictable, Treasury bonds have also become less volatile. Bond market leverage, as measured by primary dealer borrowing in the repo market, has doubled over the past three years, to about $1.25 trillion, according to investment research firm Bianco Research.

Recent surveys by both the Federal Reserve and the U.S. Office of the Comptroller of the Currency point to looser lending practices. The Fed's Senior Loan Officer Opinion Survey in October reported that "all domestic and foreign respondents that have eased their lending standards . . . pointed to more aggressive competition from other banks or nonbank lenders as the most important reason for doing so." The banks in the OCC's contemporaneous survey also alluded to competition, as well as a higher risk appetite and the more benign economic outlook, as among the chief reasons for their easing underwriting standards for the third year in a row.

Banks are not the only financial institutions competing fiercely with one another for profits. Hedge funds play an increasingly important role in the credit markets, providing liquidity to the housing market by buying mortgage-backed securities and fueling the growth of leveraged buyouts and structured finance. The Bank of England's Gieve has warned that competition among hedge fund managers could lead to trouble in the future. "The history of financial crises," he observed last July, "is replete with injudicious attempts to 'keep up with the Joneses.'"

As hedge funds are lightly regulated, little is known about the true extent of their leverage or the positions they are taking. However, their capacity to leverage is potentially enormous. A July 2005 paper by Fitch Ratings suggests that by borrowing five times its assets and investing in the riskiest part of a structured security such as collateralized mortgage obligations, a credit hedge fund could in theory become the marginal lender on $850 million worth of residential securities by committing just $10 million of its own funds.

Hedge fund managers have a huge incentive to take outsize risks, as they generally keep 20 percent of the gains while losses fall elsewhere. Performance fees are paid annually. Because credit busts are infrequent, managers stand to amass large personal fortunes even when making loans that are fated to produce losses over a long stretch. Fitch also observes that many credit hedge funds rely on short-term financing to pursue leveraged strategies and warns of "a synchronous deleveraging of credit hedge funds as a new risk element in the credit markets."

The financial innovations of recent years have taken risk off the balance sheets of banks. Lenders can now use credit derivatives to protect themselves against the possibility of a default. Loans are increasingly insured, parceled up and sold in the secondary markets to hedge funds and others. Yet innovation in structured finance is also being used to bypass regulations intended to safeguard the credit system, as Minsky suggested would be the case.

The sellers of credit default protection are not required to hold the same capital reserves as banks. Regulatory arbitrage, together with the search for more yield in an age of low interest rates and declining risk premiums, appears to lie behind much recent invention in this field. Satyajit Das, a derivatives expert and the author of Traders, Guns & Money (FT Prentice Hall, 2006), suggested in an interview with Financial Engineering News that "the level of product innovation has run far in advance of the capacity to utilize these products and the ability to understand the risks and long-term consequences."

The recent surge in leveraged-buyout activity is another consequence of the decline in financial volatility. Private equity funds have raised more money than ever before. The amount of leverage the private equity outfits pile onto the companies they acquire -- as measured by the ratio of debt to pretax cash flow -- has crept ever higher. And the amount of equity that buyout firms inject into their deals has diminished. Joshua Galaun, a credit strategist at Dresdner Kleinwort, contends that in some cases private equity firms have dispensed with equity and are financing their acquisitions entirely with debt.

The risks are also rising for those who lend to buyouts. Leveraged loans and high-yield bonds come with covenants that are intended to protect creditors. Yet despite record loan volumes, the average number of covenants has been declining, according to Fitch Ratings. Buyouts are also being financed with riskier debt, such as subordinated second-lien loans and payment-in-kind provisions, which allow borrowers to decide whether to pay coupons in cash or with an additional issue of bonds. Furthermore, large LBOs are occurring in sectors, such as technology, whose cash flows used to be considered too volatile to support high debt levels.

Low numbers of defaults and a less volatile bond market make high-yield bonds appear safer than in the past. But junk has never been junkier. The high-yield-bond market is now populated by companies with much lower credit ratings than at the end of the Michael Milken era in the late 1980s. Martin Fridson, editor of Distressed Debt Investor, recently warned that a recession as mild as that of 1990­'91 could produce a default rate for non-investment-grade bonds even greater than that witnessed during the Great Depression.

LIQUIDITY AND CREDIT

Credit has a paradoxical effect on stability. Although debt and leverage raise the level of risk, credit provides the markets with liquidity that serves to dampen volatility. Stock market volatility is inversely related to corporate profits. Credit growth boosts earnings, which in the U.S. have recently touched 40-year highs relative to GDP, thereby reducing volatility. Fridson suggests that the low current levels of distressed debt can partly be explained by the fact that many potentially troubled companies have access to finance. This keeps them out of the bankruptcy courts. Finally, Pimco's McCulley points out that the increased demand for risky assets has served to push down their volatility.

At the close of 2006, the markets were flush with liquidity. If credit were to take flight, however, the rocks submerged by this tide of liquidity might suddenly be revealed. This process already appears to be under way in residential real estate, where slowing home price inflation has been accompanied by a decline in mortgage growth, a drop in home sales and a rise in delinquencies on subprime loans.

Two contrasting hypotheses can explain recent developments in the financial world. The Great Moderation holds that owing to better policymaking and structural improvements to the financial system, both the economy and markets are more stable than in the past. The newfound stability is viewed as a secular development. In other words, it's here to stay. Therefore lower credit spreads and higher levels of leverage are justified. Investors persuaded by this view will have few qualms about buying risky assets despite their historically low yields.

Hyman Minsky, on the other hand, suggests that people's response to stability engenders instability. Such behavior is not necessarily irrational, as there are profits to be earned and bonuses to collect as long as the good times last. In fact, the cycle may extend as long as credit flows and people are hungry for risk. Yet Minsky's credit cycle heads inexorably toward a bust. Investors who accept this analysis will probably conclude that risk and reward are currently out of whack. They will position their portfolios defensively, keeping cash on hand to spend when the rewards for taking risk appear more compelling.